By taking a quick step into the readily ascertainable world of interest rate spreads, you will discover the likelihood of either a downturn or upturn in real estate sales activities one year from now. To see if a recession is coming, you need look no further than the amount of the interest rate spread between three-month and ten-year Treasuries, called the yield spread. [See the Cleveland Federal Reserve Bank's The Yield Curve, December 2008]

The long-term market rate

The yield spread is the difference between two key interest rates:

• the ten-year Treasury note rate (or long-term rates); and
• the three-month Treasury bill rate (or short-term rates).

Bond market investors set the ten-year Treasury note rate for returns on their ten-year investments in government notes, called long-term investments. Collectively, bond market investors are good at what they do; pulling from an immense breadth of information to determine the rate they require in their long-term investments in the bonds issued by government, business and real estate sectors.

Their personal interest in the success of their investments provides us with a ready gauge for what they, in their collective wisdom, determine economic conditions will be in the future.

To make a profit on these long-term investments, bond market traders must take into account the Fed’s monetary policy and the resulting economic conditions that policy places on future markets. These private forecasts of future economic conditions are translated into the rate they will accept on a ten-year Treasury note, which encompasses two discrete elements:

• the perceived future rate of inflation, called the inflation risk premium built into the ten year Treasury note (T-note) rate, as controlled by the Fed in its frequent setting of short-term interest rates; and
• the desired fixed rate of return on the investment in excess of the future rate of inflation, called the real rate of earnings.

The wisdom of these forward-looking long-term investors about the inflation they anticipate in future years contains one part of the prophetic information about looming recessions and rebounds in the economy. [For more information on the ten-year Treasury note rate, see the most recent first tuesday Rate Page.]

The short-term market rate

The second piece of information needed to calculate the yield spread is the interest rate on the three-month Treasury bill. This interest rate is managed by the Fed as the base price of borrowing money for the short-term. The Fed has direct control over this rate (through its Fed Funds Rate), and uses short-term rates as a tool to either:

• stimulate business and economic growth to stave off deflation and economic stagnation – jobs – by lowering the interest rate and allowing banks (and through them, businesses and consumers) to borrow money easily and cheaply; or
• dampen business and slow economic growth to fight inflation and excess demands for labor by raising the interest rate at which banks may borrow money (and in turn increase the cost of borrowing by businesses and consumers). [For more information on the three-month Treasury bill rate, see the most recent first tuesday Rate Page.]

Collectively, the Fed’s use of short-term interest rates and other infusions and withdrawals of dollars to control the economy is known as monetary policy. They print it and peddle it as their apolitical institutional job.

Interplay between the treasury rates = the yield spread

Calculating the yield spread is simply a matter of subtracting the three-month T-bill rate from the ten-year T-note. [See The Yield Spread chart accompanying this article.]

However, it is the magnitude of the difference between the rates that gives the yield spread its predictive power.

The Fed’s use of monetary policy to lean against inflation or deflation gives bond market investors data on how inflation will play out in the future. Bond market investors look at the Fed’s current use of short-term rates in their constant fight with inflationary and deflationary pressures to determine the likely forward impact of the Fed’s actions. They then set the rate they will accept on ten-year notes to recapture the annual loss they anticipated in the dollar’s purchasing power due to the Fed’s action — the inflation risk premium — in addition to their desired future real rate of earnings.

On any given day:

• short-term interest rates indicate what the Fed has determined they must do to combat inflation (or deflation) or address any other current deviation from acceptable financial and job market conditions; and
• long-term interest rates reflect the bond market’s judgment of the effect the Fed’s short-term actions will have on the economy long-term, and in turn their investments.

Generally, a lower or declining yield spread indicates a less vigorous economy in the near future, say one year forward. This declining yield spread is a result of bond market investors seeing less future growth resulting from the Fed’s short-term rate activity, such as the Fed raising short-term rates to combat the increased risk of inflation. This scenario predicts the likelihood of an economic recession one year forward. In our current December 2010 economy, a declining yield spread would signal a slowdown in the pace of the recovery and, possibly, a double-dip recession (as occurred in 1980-81), which would not be pleasant for the economy and worse for the real estate market.

On the flip-side of an economic cycle, a higher or rising yield spread indicates a more vigorous future economy — or at least one that is not in much danger of recession one year forward. While good for bond market investors whose actions are full-speed-ahead for profit, a too-high yield spread (and its resulting boom) poses a danger of inflation the Fed must curtail to protect the growth of future jobs and consumer prices.

A too-sharp correction from a high yield spread can potentially send the yield spread into low or negative levels; thus, a high yield spread is not without its own set of risks in the closely-watched game of monetary policy. The Fed is closely watching the current yield spread in 2010, as continuing to keep short-term rates low creates an environment ripe for consumer and asset (property) price inflation, and any misstep in raising the rates to quickly to correct a growing inflation outlook could result in the dreaded double-dip recession.

The pump priming of QE2 just underway by the Fed is to effectively reduce their overnight inter-bank rate to around a minus 0.5% rate, which of course they cannot directly do without risking a negative impact on investment, production and jobs – as well as fight the enemy of disinflation which continues to approach zero. [For more information on the Fed’s reaction to the current low-rate environment, see the February 2010 first tuesday article, Discount window interest rate raised by 0.25%.]

Interpreting the yield spread chart: the Fed way

In 1996, Fed economists Arturo Estrella and Frederic Mishkin examined the spread between the long-term and the short-term rates and discovered a pattern which disclosed the likelihood of an economic recession in the ensuing four quarters (one year forward, to the layman). [See the chart at the top of this article]

In the chart referenced above, the blue line tracks the yield spread from January 1954 – October 2010. Recessions are represented by the vertical gray bars across that same time period. The green line represents the point for which the probability of recession begins, as assigned by Estrella and Mishkin. Under Estrella and Mishkin’s analysis, yield spreads smaller than 1.21% predict successively greater probabilities of recessions one year forward.

However, consider that truths told by prognosticators, even ones as erudite as the Fed wizards, are still beholden to the true conditions of the economy. The probability of a recession as told by Estrella and Mishkin’s chart is neatly presented and gives a Fed perspective of when recessions will occur and their severity.

In reality, a yield spread chart provides an even quicker judge of a coming recession (or rebound) one year forward, no matter its degree of severity.

Reading the yield spread chart: the quick and easy way

The orange line in the chart represents zero. When the yield spread dips below zero, or in other words when the long-term rate is lower than the short-term rate, an inversion of the two key interest rates has occurred. Yield spread inversion signals a crossover disturbance in the two rates controlling the yield, consisting of:

• the bond market reducing its forecast for future demand for money in preparation for a downturn in the economy; and/or
• the Fed quickly raising interest rates to correct inflation or too-loose market conditions, indicating a swifter-than-normal retraction in the money available in the economy.

Observe on the chart that a recession follows nearly one year after each inversion of the yield spread, and sometimes even after a near-inversion of the yield spread. Whether brought about mainly by the bond market’s low confidence in the future conditions of the economy, or a persistent short-term rate change by the Fed, this inversion always flags the coming of an economic slowdown one year forward — a recession as mapped by the vertical gray bars on the chart.

That crossover moment gives the real estate broker and agent the heads up to adjust their conduct to match which will become a measurably reduced volume in sales, lending and leasing one year forward, followed within another year by a drop in prices, rents and loan rates. It’s axiomatic, my dear reader.

In May, 2011, the yield spread was +3.13%, the difference between the three-month rate (0.04%) and the ten-year rate (3.17%) on Treasuries.

Thus, the likelihood of a decline in general business and real estate activities over the next 12 months – 2011 – is around 0.5%: next to nothing. No chance of a recessionary downward trend remains before Mid-2012.

This positive forecast sent by the May 2011 yield spread is in sharp contrast with the negative yield spread during the last half of 2006, a spread of -0.205% when the three-month interest rate was higher than the ten-year note rate. The negative spread predicted a 40% chance of a recession to take hold one year forward in December 2007 — the month we formally entered the previous recession. A review of any period during the history of treasuries produces the same “right on” picture of economic conditions one year forward.

Lesson: when the yield curve goes negative, we will most certainly be in a recession within 12 months. Each of the past seven recessions have been preceded by a negative (inverted) spread one year earlier. Said another way, each time since 1960 that the yield spread went negative we were in a recession approximately 12 months later.

Real estate’s stake

Real estate was a key player contributing to the excesses that brought about the recent Great Recession and the concurrent financial crisis. The yield spread was clearly decreasing in the years prior to the implosion of the real estate bubble. The concerted and abrupt effort of the Fed to correct its short-term rates beginning mid-2004 came only after allowing the market to go hog-wild for too long — an observation derived from hindsight. Coupled with the long-term bond market’s increasing skepticism about the strength of the markets in the immediate future, the short- and long-terms together created a falling yield spread illustrative of the great fall real estate would take in the year following the inversion in mid 2006.

The collective efforts of real estate professionals in-the-know will help to nurse the real estate market back to health. As more and more brokers and agents understand the workings of the yield spread as a gauge of the economy’s direction one-year forward, the industry-wide frenzy to over-build, over-price and over-sell will be tempered by the steady direction taken by the level-headed professionals within the real estate industry.

The real estate market will need the guidance of well-informed real estate experts whenever the Fed implements a rate increase which causes the yield spread to slip below zero and takes the economy back into a period of recession.

Brokers and agents who dare themselves to track the yield spread will be given the foresight to shift their advice and spending routines before the changes in the market actually occur. In doing so they will seek out recession-proof niches of real estate (such as real estate owned (REO) sales, or property management) in which to weather the storm.

If you hadn’t become convinced of a real estate downturn by tumultuous events:

• adjustable rate mortgage (ARM) rates began increasing after August 2004;
• the volume of real estate sales and mortgage originations peaked in August 2005;
• real estate prices in Southern California peaked in January 2006; and then
• the yield curve went negative — inverting with the three-month rate overtopping the ten-year T-note rate in mid-2006 – fully warning observers of the inevitable end of the boom and the beginning of a full-blown recession by late 2007.

You were forewarned! Did you take advance steps to isolate yourself from real estate’s financial disaster in 2008 through 2011 — the after affects of which will weigh upon the real estate market through at least 2015?

This cyclical downturn is not your ordinary business recession which infects one or two major regions of the United States. All regions have now been affected at the same time (some more, like California or Florida; some less, like North Dakota or Montana) as well as all countries in the world to some degree. The only locomotive standing with the strength to forcibly pull all economies out of the recession is the safe haven based on the Fed’s almighty US dollar. Hence, Cash Is King — if it’s US dollars you hold (or Yen or Euros).

To look forward now by a check with the yield spread is to see the positive strength the general US economy will hold going into 2012 — one year forward.

Don’t be fooled by the rising price of gold, fueled by those who fear impending inflation with little regard for the logic of the yield spread’s solid track record. The gurus of gold always pitch the new paradigm, and the followers always find it does not exist. A look at the 10-year and 30-year bond rates indicates no inflation for another decade.

However, be prepared for real estate to work its way through the massive excess inventory (both on the market and yet to be placed on the market), as that will take well into 2012 for buyers to absorb. Banks still need to figure out either how or when, or both, to process their delinquencies and real estate owned (REO) portfolios.

Parting message? Keep the yield spread at hand, and consider it when making business decisions: it will pay off as soon as the coming year.

We are certain about the movement upward of the general economy. But real estate sales? For that, you must watch what the Federal Deposit Insurance Corporation (FDIC) and Congress do to clean out the huge number of bad banks in California and convert them into good banks that lend to small businesses and young energetic upstarts. Those borrowers will then put people to work, who will then spend, and so on — all part of the soon-to-come virtuous economic cycle.

Welcome aboard for the ride.